Placing Bets on War and Peace

AS AUTHORITIES DOUBLED their efforts to find Osama Bin Laden and war drums sounded louder, Asian markets lost ground last week, though the dollar's strength reduced the losses for global investors. In local currency terms, Japan's benchmark Nikkei 225 dropped 2.6%, Hong Kong's Hang Seng lost 2.4%, and Australian equities fell 2%.

Late last week, two sons of Osama bin Laden, including the eldest, a rising star in al Qaeda, were captured by authorities. Meanwhile, President Bush announced that only days remained for a diplomatic solution in Iraq to be achieved.

The likely effects of a war on Asian markets is a topic of heated debate, particularly since nobody agrees on what scenario is most probable. Thank goodness for Don Hanna, the chief Asian economist with Salomon Smith Barney in Hong Kong. He dreamed up three probable scenarios with the help of the Center for Strategic and International Studies and Citigroup. Then he quantified their effects on the regional economy.

To Hanna, the most benign and plausible scenario, which he calls the "base case," involves a quick collapse of Saddam Hussein's regime once fighting starts. There would be limited civilian deaths, no meaningful use of weapons of mass destruction against U.S. troops or Israel, no major acts of terrorism in the U.S. or the U.K. and allied countries, no reduction in OPEC oil production, and in fact, an increase in Saudi production.

Hanna pegs as 30% to 40% likely an "intermediate-case" scenario, in which battles could rage for 12 weeks on unexpected resistance. Serious collateral damage would ensue, and low-level civil tensions and clashes would last well after the main fighting and major covert efforts to attack targets in the U.S. and the U.K. would be discovered and averted. In this scenario, Iraq would inflict limited damage on oil facilities in the region and make limited use of weapons of mass destruction against U.S. troops and Israel.

Then there's the worst-case scenario, which Hanna figures is 5% to 10% likely. The worst case might include fighting that lasts as long as six months, intense urban warfare with significant casualties and collateral damage inflicted on U.S.-led allies. This script would also feature the withdrawal of Britain, Turkey or another Gulf nation from allied forces led by the U.S.; Iraqi deployment of weapons of mass destruction, which would significantly damage oil facilities; serious Israeli intervention and massive regional political unrest.

Much hinges on oil prices. Under the base-case, Hanna sees oil trading at $35 a barrel this quarter, falling to $21.80 by the fourth quarter of next year. Under the intermediate scenario, oil would spike to $42 a barrel this quarter and then fall to $30 by the fourth quarter of '04. Worst-case, oil spikes to $45 a barrel this quarter, and up to $80 next quarter, before falling to $60 between June and September. Hanna sees the price dropping to $40 again at the end of '04.

An Iraq war also would have many indirect effects. For example, the Philippines depends heavily on remittances by overseas contract workers, many of whom work in the Gulf. War would squeeze consumption and investment, hurting big exporters. (One is Singapore, the value of whose exports equals 180% of its economy.)

Indeed, Hanna writes, Singapore generally fares worst under all three scenarios, given its open economy, its need for oil imports, and the fact that 6% of its gross domestic product comes from tourism. Next in line: open economies with lousy oil balances that depend on tourism -- say, Thailand and the Philippines. Both Malaysia and Indonesia are net oil exporters, though Malaysia relies heavily on tourism too.

Under the intermediate case, Hanna figures the U.S. economy would decline by 1.4% this year and 1.5% next year. The economy of non-Japan Asia, in turn, would lose 0.7% this year and 0.4% next year. Singapore would lose 2% this year, Hong Kong 0.6%, Malaysia 1%. Indonesia and South Korea would be least affected, showing a 0.5% decline this year and flat growth next year.

Even mighty China, one of the few spots of growth in a sluggish world, would lose 0.9% this year and 0.3% next year.

Those numbers get a lot worse under the worst-case scenario. Singapore loses 5.3% this year, and then rebounds to 7.4% growth the following year, assuming a sharp, V-shaped recovery. Thailand loses 3.8%, the Philippines 3.3%, Malaysia 3.2%. Korea, India, Indonesia and Taiwan are least affected, and would probably lose between 0.7% and 1.8% this year. Still, per-capita incomes would "take several years to climb back from the worst-case outcome," says Hanna.

Rosgen and Leung think South Korea and Taiwan would fare best, given their wealth of volatile stocks -- tech issues, brokers and airlines. Falling into the laggard camp would be Malaysia and Indonesia, owing to weaker oil prices "post closure on Iraq." China, too, will underperform, given the makeup of the Chinese market. "Leaving aside telecoms, expressways and utilities are not beta plays -- nor are oil stocks," Rosgen and Leung write.

Asian valuations are now back to their levels of January 1991 -- at book value, even though debt on Asian balance sheets is far lower and Asian markets trade at discounts to other markets with roughly similar returns on equity. "A case of pay less, get more," the analysts say.

When stock markets rally at last, that's a plus for the U.S. dollar. Then markets will give some back because it takes the economy and earnings six-to-nine months to show improvement. Asia, still a U.S.-dollar bloc with undervalued currencies, historically performs well when the greenback is weak.

SHARES OF CATHAY PACIFIC, Hong Kong's dominant carrier, tacked on 2% last week, to HK$11.10, after the airline said net profit quintupled to HK$3.98 billion Hong Kong dollars (US$510.2 million). It also said it would pay a full-year dividend of HK$0.72, up from HK $0.17 a year earlier. That makes a 60% payout and a yield of 6.2%.

Cathay Pacific
's earnings radically beat even Barron's own optimistic expectations, outlined in last week's issue ("Gaining Altitude," March 3). Traffic was exceptionally good on the passenger and cargo sides, and the airline also dramatically reduced costs with fuel hedging and other measures. Operating expenses in 2002 fell 3.6%, while fuel costs dropped 8%, even though the price of jet kerosene rose 45% in 2002.

James Hughes-Hallett, Cathay's chairman, said that a war in Iraq might weaken demand for air travel and boost fuel prices, hurting earnings. That, combined with runup in Cathay shares before the earnings announcement, led some to strike Cathay from their buy lists. Yet many remained sanguine, including analysts Simon Gresham and Julie Lim of Merrill Lynch, who wrote that 2002's strong performance "clearly provides significant insurance against war in 2003." They maintained their buy rating and price target of HK$15 a share.

Meanwhile,
Swire Pacific,
which owns 45% of Cathay, reported that 2002 net profit rose 31%. The company proposed a final dividend for Class A shares of HK$1.30, up from HK$1.12 a year earlier. Swire closed last week at HK$32.40.

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